Fund Investing

The Canadian Securities Administrators, the organization consisting of all provincial and territorial securities regulators, want mutual fund and securities dealers to disclose the dollar amounts of trailing commissions they receive that can be tied to your account. This isn't a new initiative; I wrote about it in this column a year ago.

About the Author

Steven G. Kelman is president of Steven G. Kelman & Associates Limited. His company provides specialty publications and training for the mutual fund industries. Steven is the author of several personal finance books and is author or co-author of courses offered by the Investment Funds Institute of Canada, including the Ethical Conduct and Behaviour continuing education course and the Labour-Sponsored Investment Funds course. He received a B.Sc. from McMaster University, an MBA from York University and holds a Chartered Financial Analyst designation.

Specifically, you will receive from your dealer a statement to the effect that "We received $XX in trailing commissions on the investment funds you owned during the period.

"Investment funds pay investment fund managers a fee for managing their funds. The managers pay us ongoing trailing commissions from that management fee for the service and advice we provide you. The amount of the trailing commissions depends on the sales charge option you chose when you purchased the fund. You are not charged the trailing commission or the management fee. But, as is the case with any investment fund expense, trailing commissions are likely to affect you because, in most cases, they reduce the amount of the fund's return to you. Information about management fees and other charges to your investment funds is in included in the prospectus or Fund Facts document for each fund."

A better way of putting it is that most investors don't understand that trailing commissions are a significant portion of the ongoing costs of holding mutual funds and other investments that pay trailers. There are funds sold directly by fund companies to investors that don't pay trailers; these charge a lower management fee than those that do pay trailers. The difference of course stays in your pockets.

The regulators' research also shows that investors rely heavily on their dealers' advice on buying, selling or holding securities but they don't realize that they are charged indirectly for these trailers and that trailers are paid on an ongoing basis.

Typically the annual trailer paid on an equity fund sold with a front-end commission or zero commission is one percentage point of the market value of that specific fund in your account, while the trailer paid on an equity fund sold on deferred declining redemption fee basis is half of one percentage point.

Also, I should state that trailing commission is a misnomer. It is in fact a service fee that is paid to whoever is the dealer of record on your holding. In 1994 the Investment Funds Institute of Canada convinced the Canada Revenue Agency to treat these amounts as a financial service or commission which was GST exempt. The CRA changed its mind several years ago and trailer fees have been subject to GST or HST since Dec. 14, 2009.

Trailers work like this: The fund management company pays the dealer the trailer fee and the dealer pays a portion to your advisor. The CRA document includes an example that discloses activities performed by an advisor after the sale that make trailers a GST/HST taxable service. These include:

regularly meeting with or contacting the client to review the status of the account and the appropriateness of the units held in the account in light of the investor's financial needs and investment objectives;

ensuring that the client fully understands the nature of the units held in the account and all of the implications of holding the units;

answering any questions that the client may have regarding the account, or the units held in the account;

recommending any appropriate change in the account or in respect of the units held in the account; and

assisting a client in exercising any right or privilege in respect of the account or the units held in the account.

I will speculate that there are many advisors who actually earn their trailers by providing these or similar activities with their clients and document them scrupulously. But I suspect that those investors who have online accounts with discount brokerage firms get none of these services, even though dealers receive trailers based on the value of the funds those investors own.

If the regulators are looking for better disclosure, perhaps they should require each dealer to list for each client the specific services provided to the client in the past year that justify the trailer received.

Of course dealers and fund companies may argue that it's the fund management company's money that is paid to the dealer and not the investor's.

I disagree. You should consider the trailer fee your money because if you are dissatisfied with the service you receive and move your account to another dealer or to another advisor within the same firm, the trailer moves with your account to compensate your advisor for the after-sale services you may or may not receive.

Also, many fund companies offer Class F units of mutual funds. No trailer fees are paid on these. These are sold primarily by advisors who charge clients an annual fee based on the value of their assets. They buy funds charging zero commission and do not receive a trailer.

As I wrote in this column two years ago some countries prohibit trailer fees. The Canadian regulators aren't proposing this and take the view that different compensation models benefit consumers.

What they do want is more transparency, including an annual compensation report that includes the actual dollar amount of trailers generated by a client's portfolio.

They may get some unintended consequences. Disclosing the amount of trailing commissions received from numerous fund management companies, and then allocating these on an account-by-account basis, will undoubtedly be costly for dealers. Ultimately they will be paid for by investors in the form of higher management fees.

I expect some dealers and advisors will find it easier to switch their business models from mutual funds to insurance company segregated funds. Many dealers and advisors perceive segregated funds as far less regulated than mutual funds. Others will adopt a fee-based business model and switch their larger clients to Class F shares to avoid the hassle the disclosure requirement will bring.

On a broad scale, such changes will push the costs of transparency on to the small investor who may not get any perceived benefit.

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